Monday, April 07, 2008

I've been involved in an activist campaign aimed at increasing shareholder value at Yahoo!(YHOO - Cramer's Take - Stockpickr) for the last 15 months. When I started, I hoped that some swift action on the part of Yahoo!'s management and board would help the Internet pioneer make better use of its brand and traffic to deliver superior returns for its shareholders.

However, it took Microsoft's(MSFT - Cramer's Take - Stockpickr) 62% premium offer, not the bold moves of Yahoo!, to finally unlock that value. (From Jan. 5, 2007, when I launched my activism, to the day Microsoft announced its bid, Yahoo!'s delivered a +11.27% return vs. -4.59% for the S&P.)

The deal on the table from Microsoft is a good one for Yahoo! shareholders (although we'd like better). It's certainly better than the prospect of an independent Yahoo! or a shotgun marriage with Time Warner's(TWX - Cramer's Take - Stockpickr) AOL or News Corp's(NWS - Cramer's Take - Stockpickr) MySpace. That's a recipe for a quick return to a sub-$20 stock price.

Yahoo!'s stock price would likely sink a lot more than that if Microsoft walked away from its offer (as some rumors Friday suggested it might). From Feb. 1 to April 4, Google's(GOOG - Cramer's Take - Stockpickr) stock is down over 16%. If Microsoft's deal had never come to pass, Yahoo!'s stock would likely have gone down just as much, if not more, meaning it would be around $16.There appears to be consensus among the other Yahoo! shareholders I've spoken with that $31 a share is better than $16.

Most press coverage of this takeover drama has failed to observe that this is also a very good deal for Microsoft and its shareholders -- and it still would be, even if they upped the price a few more dollars (still a likely possibility, despite Steve Ballmer's letter over the weekend that he was going to launch a proxy fight in three weeks if there was continued silence from Sunnyvale).

Several Microsoft shareholders have groused about buying Yahoo! They worry that the price is too high, it forces Microsoft to issue debt, it uses up its cash, and the integration risks are plentiful. One analyst chuckled after the deal was announced that Google co-founders ""Sergey and Larry are going to have no problems sleeping" thinking about the combination of Yahoo! and Microsoft.

Microsoft actually was the target of shareholder discontent in 2006. It never coalesced into an organized activist effort, but many -- like Joe Rosenberg, Chief Investment Officer of Loews Corporation voiced complaints. There was $35 billion in cash sitting on the balance sheet, with another $10 billion in invested securities. The stock had gone sideways since 1998 and Xbox seemed like a sinkhole.

However, from May 2006 until just prior to the Yahoo! deal being announced, Microsoft was up 35% vs. about 2% for the S&P. It's still 15 points ahead of the S&P, even after the pull-back in the last two months relating to worries about the Yahoo! deal.

Microsoft has operated well in the last two years. They also upped their dividend, delivered Windows Vista, and nobody has used the word "sinkhole" since hearing about a game called "Halo 3" for the Xbox.

But Rosenberg's still not happy, at least not with Ballmer or this deal for Yahoo! He said recently: "It's a bad reflection on Ballmer that he's willing to pay a ridiculous price for Yahoo! Microsoft is not going to earn anything like a reasonable rate of return on its investment in Yahoo! It just doesn't make sense." He went on to ask: "Can you think of a major tech deal that ever worked out?"

Of course there have been major tech deals that have achieved greater scale, with cost savings. There's no reason that the technology industry can't consolidate, with the acquirer getting more customers at lower costs like any other industry, as Larry Ellison has shown for the last five years at Oracle.

Yahoo! will bring many benefits to Microsoft. Despite all the investments Microsoft has made since the mid-90s, its Online Services Division is still the company's ugly duckling in terms of size and profitability. In the most recent quarter, its revenue was $863 million -- far behind any other division -- and it lost $245 million (more than twice the previous year). Yahoo!'s most recent quarter logged revenue of $1.83 billion with $191 million in operating income. (Google, by the way, did $4.83 billion with $1.44 billion in operating income.)

Microsoft can do three things with its Online Services Division: (1) shut it down, (2) incrementally hire engineers to close the gap with Google, or (3) make a bold acquisition to get bigger and faster.

This market is too big and strategically important to the rest of Microsoft to cede to Google. The Microsoft shareholders who are unhappy with this deal want them to pursue option 2. Microsoft loves hiring engineers, but it can't give the division another 13 years to catch up. They have to close the gap with Google and they know it.

With a united Yahoo!/Microsoft, the Online Services Division jumps to $2.7 billion in annual revenue and can be a heck of a lot more profitable. Yahoo! has a lot of great assets and engineers, but it's not known for operational excellence and right-sizing the organization. There are many great people for Microsoft to keep, but many who can go.

Microsoft can answer its critics by saying their former cash hoard will be gone when this deal gets done and they will be in a much stronger position to compete in a significantly large and growing space. Their ability to carry top-grade debt is unquestionable, and Yahoo! will bring significant growth opportunities that Microsoft wouldn't otherwise have.

Microsoft critics mistakenly think this deal is only about beefing up the weak sister Online Services Division. It's not. This deal is about protecting the central nervous system of Microsoft itself: Windows and Office. That's because Web services are the new versions of Windows and Office.

The world is moving to something called Software as a Service, where your software lives on the Web, not your desktop. Google Docs is a slimmed down version of Office. There's a free version and a pay version of the software, both with personalized ads to supplement Google's revenue stream. Few of us use Google Docs today but that might be different in 5 years. TechCrunch recently pegged Google Docs revenue for last year at $400 million (2% to 3% of Google's total revenue and 10 times the size of the previous year's Google Docs revenue). Microsoft can hang on to it core business for as long as it can hoping the world won't change or it can start preparing now for the possible day when software lives on the Web, combating what Clay Christensen calls the Innovator's Dilemma. Sometimes, the best defense is a good offense. Yahoo! allows Microsoft to be stronger in search against Google and, more importantly, stronger in Web services.

Rosenberg and others are right to suggest that big acquisition integrations can fail but they can also certainly succeed, if done right. The smartest people at Yahoo! will see this deal as a chance to work with even smarter people, with more opportunities in front of them, more resources behind them, and fewer managerial distractions around them.

And, what about Sergey and Larry not losing any sleep? Google is clearly still in a dominant position in search. However, I don't think Eric Schmidt would be complaining that Microsoft and Yahoo! together are going to "break the Internet," if they weren't concerned.

Microsoft has to get its Online Services Division to perform now; just as they did with Xbox back in 2006. If they do, as they should with the help of Yahoo!, there will be no need for shareholder activists to target Redmond.

At the time of publication, Jackson was long YHOO.

Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

I've been involved in an activist campaign aimed at increasing shareholder value at Yahoo!(YHOO - Cramer's Take - Stockpickr) for the last 15 months. When I started, I hoped that some swift action on the part of Yahoo!'s management and board would help the Internet pioneer make better use of its brand and traffic to deliver superior returns for its shareholders.

However, it took Microsoft's(MSFT - Cramer's Take - Stockpickr) 62% premium offer, not the bold moves of Yahoo!, to finally unlock that value. (From Jan. 5, 2007, when I launched my activism, to the day Microsoft announced its bid, Yahoo!'s delivered a +11.27% return vs. -4.59% for the S&P.)

The deal on the table from Microsoft is a good one for Yahoo! shareholders (although we'd like better). It's certainly better than the prospect of an independent Yahoo! or a shotgun marriage with Time Warner's(TWX - Cramer's Take - Stockpickr) AOL or News Corp's(NWS - Cramer's Take - Stockpickr) MySpace. That's a recipe for a quick return to a sub-$20 stock price.

Yahoo!'s stock price would likely sink a lot more than that if Microsoft walked away from its offer (as some rumors Friday suggested it might). From Feb. 1 to April 4, Google's(GOOG - Cramer's Take - Stockpickr) stock is down over 16%. If Microsoft's deal had never come to pass, Yahoo!'s stock would likely have gone down just as much, if not more, meaning it would be around $16.There appears to be consensus among the other Yahoo! shareholders I've spoken with that $31 a share is better than $16.

Most press coverage of this takeover drama has failed to observe that this is also a very good deal for Microsoft and its shareholders -- and it still would be, even if they upped the price a few more dollars (still a likely possibility, despite Steve Ballmer's letter over the weekend that he was going to launch a proxy fight in three weeks if there was continued silence from Sunnyvale).

Several Microsoft shareholders have groused about buying Yahoo! They worry that the price is too high, it forces Microsoft to issue debt, it uses up its cash, and the integration risks are plentiful. One analyst chuckled after the deal was announced that Google co-founders ""Sergey and Larry are going to have no problems sleeping" thinking about the combination of Yahoo! and Microsoft.

Microsoft actually was the target of shareholder discontent in 2006. It never coalesced into an organized activist effort, but many -- like Joe Rosenberg, Chief Investment Officer of Loews Corporation voiced complaints. There was $35 billion in cash sitting on the balance sheet, with another $10 billion in invested securities. The stock had gone sideways since 1998 and Xbox seemed like a sinkhole.

However, from May 2006 until just prior to the Yahoo! deal being announced, Microsoft was up 35% vs. about 2% for the S&P. It's still 15 points ahead of the S&P, even after the pull-back in the last two months relating to worries about the Yahoo! deal.

Microsoft has operated well in the last two years. They also upped their dividend, delivered Windows Vista, and nobody has used the word "sinkhole" since hearing about a game called "Halo 3" for the Xbox.

But Rosenberg's still not happy, at least not with Ballmer or this deal for Yahoo! He said recently: "It's a bad reflection on Ballmer that he's willing to pay a ridiculous price for Yahoo! Microsoft is not going to earn anything like a reasonable rate of return on its investment in Yahoo! It just doesn't make sense." He went on to ask: "Can you think of a major tech deal that ever worked out?"

Of course there have been major tech deals that have achieved greater scale, with cost savings. There's no reason that the technology industry can't consolidate, with the acquirer getting more customers at lower costs like any other industry, as Larry Ellison has shown for the last five years at Oracle.

Yahoo! will bring many benefits to Microsoft. Despite all the investments Microsoft has made since the mid-90s, its Online Services Division is still the company's ugly duckling in terms of size and profitability. In the most recent quarter, its revenue was $863 million -- far behind any other division -- and it lost $245 million (more than twice the previous year). Yahoo!'s most recent quarter logged revenue of $1.83 billion with $191 million in operating income. (Google, by the way, did $4.83 billion with $1.44 billion in operating income.)

Microsoft can do three things with its Online Services Division: (1) shut it down, (2) incrementally hire engineers to close the gap with Google, or (3) make a bold acquisition to get bigger and faster.

This market is too big and strategically important to the rest of Microsoft to cede to Google. The Microsoft shareholders who are unhappy with this deal want them to pursue option 2. Microsoft loves hiring engineers, but it can't give the division another 13 years to catch up. They have to close the gap with Google and they know it.

With a united Yahoo!/Microsoft, the Online Services Division jumps to $2.7 billion in annual revenue and can be a heck of a lot more profitable. Yahoo! has a lot of great assets and engineers, but it's not known for operational excellence and right-sizing the organization. There are many great people for Microsoft to keep, but many who can go.

Microsoft can answer its critics by saying their former cash hoard will be gone when this deal gets done and they will be in a much stronger position to compete in a significantly large and growing space. Their ability to carry top-grade debt is unquestionable, and Yahoo! will bring significant growth opportunities that Microsoft wouldn't otherwise have.

Microsoft critics mistakenly think this deal is only about beefing up the weak sister Online Services Division. It's not. This deal is about protecting the central nervous system of Microsoft itself: Windows and Office. That's because Web services are the new versions of Windows and Office.

The world is moving to something called Software as a Service, where your software lives on the Web, not your desktop. Google Docs is a slimmed down version of Office. There's a free version and a pay version of the software, both with personalized ads to supplement Google's revenue stream. Few of us use Google Docs today but that might be different in 5 years. TechCrunch recently pegged Google Docs revenue for last year at $400 million (2% to 3% of Google's total revenue and 10 times the size of the previous year's Google Docs revenue). Microsoft can hang on to it core business for as long as it can hoping the world won't change or it can start preparing now for the possible day when software lives on the Web, combating what Clay Christensen calls the Innovator's Dilemma. Sometimes, the best defense is a good offense. Yahoo! allows Microsoft to be stronger in search against Google and, more importantly, stronger in Web services.

Rosenberg and others are right to suggest that big acquisition integrations can fail but they can also certainly succeed, if done right. The smartest people at Yahoo! will see this deal as a chance to work with even smarter people, with more opportunities in front of them, more resources behind them, and fewer managerial distractions around them.

And, what about Sergey and Larry not losing any sleep? Google is clearly still in a dominant position in search. However, I don't think Eric Schmidt would be complaining that Microsoft and Yahoo! together are going to "break the Internet," if they weren't concerned.

Microsoft has to get its Online Services Division to perform now; just as they did with Xbox back in 2006. If they do, as they should with the help of Yahoo!, there will be no need for shareholder activists to target Redmond.

At the time of publication, Jackson was long YHOO.

Eric Jackson is founder and president of Ironfire Capital, LLC, and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

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